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Capital Budgeting

Comprehensiveness in Capital Budgeting


David Duran

The financial analysis underlying capital budgeting is a process of concentrating information;


uncoordinated basic data are collected, sifted, organized, and subjected to various quantitative
techniques - all to produce a final appraisal stressing the considerations most important to a financial
manager responsible for selecting investment opportunities. Much current thinking favors concentration
to the limit, as in Teichrow, Robichek, and Montalbano [11]: "Since the decision problem under general
conditions is extremely complicated, much of the literature is concerned with simplifying the problem by
assigning to each project a single number which indicates a 'preference.'" Here is a prescription for
maximum simplicity achieved through maximum concentration; it is also a prescription for maximum
loss of information, since concentration is achieved by ignoring (or at least playing down) complexities
and sifting out all in- formation thought to be of less than primary impor- tance. At best, the reduction
of a complex problem to a single number indicating preference will result in a minimax - if the number
selected entails less loss of information than all competing single numbers. An obvious means of
reducing loss of information (cf. Durand [3, 4]) is to use two or more numbers to indicate preference -
striving for an economic trade-off between simplicity and comprehensiveness. Although defining and
then finding an optimal trade-off is vir- tually unthinkable, the extreme position of reducing all
complexities to a single number must be far from optimal. Indeed, an overall view of the literature indi-
cates that the combined efforts of individuals seeking a single number have failed to produce one satis-
factory to all users; instead, these efforts have produced a variety of numbers, and demonstrated their
usefulness in specific applications if not in general. By now, any investment analyst with open eyes will
see before him a virtual smorgasbord of analytical techniques and numbers indicating preference. This
paper takes a bird's-eye view of the possibilities of using multiple numbers to indicate preference -
including a view of the bond market, where multiple numbers are well understood. It starts with the use
of multiple numbers to analyze a single cash- flow series, then proceeds to the use of multiple cash- flow
series to represent a single investment. It closes with a brief comment on the trade-off between
simplicity and comprehensiveness.

Multiple Numbers for a Single Cash-Flow Series

Among bond analysts the use of multiple numbers to indicate preference is commonplace. At the least,
an analyst uses a combination of yield to maturity (YTM) and term to maturity (TTM) - the first as an
index of profitability, the second as an index of liquidity or of sensitivity to changing interest rates. But
these two may not suffice. Often the coupon rate is needed in one form or other - say in the use of
current yield by a trustee responsible for providing an elderly widow with income, or in the distinction
drawn by many analysts between deep discount bonds (low coupon) and low discount bonds (higher
coupons). Finally, the sophisticated portfolio manager may use duration (cf. [1, 4, 5, and 6]) as an
improved measure of sensitivity to changing interest rates; the calculation of duration requires three
parameters - e.g., YTM, TTM, and the coupon rate.

Outside the financial markets the use of multiple numbers is by no means unknown. In a recent survey
of capital budgeting practices, Gitman and Forrester [7] asked 268 companies to report (among other
things) both primary and secondary techniques, or numbers, actually used. Of the 110 respondents, 93
in- dicated a secondary technique, implying multiple numbers, and one or two even indicated more than
one primary technique. The most popular primary listing (60 replies) was the internal rate of return
(IRR), analogous (mathematically almost identical) to YTM for bonds. The most popular secondary listing
(41 replies) was the payout period (POP). Because the sur- vey provided no cross-classifications and no
details on how techniques were used, we cannot be sure how many of the respondents used the specific
combination of IRR and POP, or how they coordinated IRR and POP. Here is a tantalizing question,
because POP is subject to two interpretations - 1) as an index of profitability, for which it is inferior to
measures like IRR,' and 2) as a measure of liquidity, roughly analogous to TTM for bonds. These two
interpretations are often confused; indeed one of the few writers to recognize them was Weingartner
[12], who suggested using POP as a constraint to supplement some more appropriate measure of
profitability, say IRR. So, one wonders, how many of the respondents 1There is an important exception -
for cash-flow series where only POP is computable. If, say, an investment of $1,000 were expected to
bring in roughly constant returns of $525 a year for about three years and then declining returns for an
unpredictable number of years, POP would be easily computable (1.9 years), but not IRR. used IRR as a
measure of profitability and POP as a constraint - more or less as suggested by Wein- gartner?

Although IRR has support from both theoreticians and practitioners, it falls short of ideal; substitutes
have been avidly sought, although none has been found to satisfy everybody. Among the substitutes
proposed are present value (PV) and two refinements derived from it - net present value (NPV) and the
net benefit-cost ratio (NBC). Unlike IRR, none of these is uniquely defined by the cash-flow series; each
depends on the choice of a cost of capital, or discount rate, which must be estimated or selected
arbitrarily. Consider the illustrative investments A and B in Ex- hibit 1. Each consists of a lump-sum
outlay of $1,500 followed by a series of regular monthly repayments - 30 repayments of $75 for A and
80 repayments of $40 for B. From this information alone, one can calculate IRR, getting 2.84% per
month for A and 2.20% per month for B - unique values ranking A before B. For calculating PV (also NPV
and NBC), however, a dis- count factor is needed, and this requires either ad- ditional information on the
cost of capital, or a purely arbitrary assumption. Exhibit 1 includes PVs corre- sponding to an assumed
discount rate of 1%/month; the results are $1,936 for A and $2,196 for B - values ranking B before A, in
contrast to the ranking by IRR. But note, if 1.75% per month had been assumed for discounting, the PVs
would have been $1,739 for A and $1,715 for B - values reversing the previous ranking and confirming
the ranking by IRR.
The import of this example is that PV (also NPV and NBC) is no better than the available estimate of the
cost of capital. If the estimate is tenuous - as usual - so too must be the resulting PV. And when the cost
of capital is represented by a range of values to allow for uncertainty, PV must also be represented by a
range - thus hardly qualifying as a single number indicating preference. Even so, PV can provide valuable
insights and aids to judgment if used as a supplement to rather than substitute for IRR or perhaps to a
combination of IRR and POP. The es- sential advantage of PV is that it exploits available in- formation on
the cost of capital - information not used to calculate IRR and POP.

If PV (or NPV or NBC) is to be used effectively as a supplement to IRR, something needs to be known
about the functional relation between the variables. The general principle that investments ranking well
in terms of PV tend to be those with a long-term com- mitment and an IRR substantially higher than the
cost of capital is almost certainly well known; what is not so well known is the following specific
equation for the net benefit-cost ratio:

NBC = ( + d)T - 1 Td,

where d is the approximate amount by which IRR ex- ceeds the cost of capital, and T is a temporal
measure closely related to Boulding's [2] "time spread" and the actuaries' "equated time" (cf. Durand
[4]). (Deriva- tion and further explanation will be found in the mathematical appendix.) Note that the
approximate relation in the second line is reasonably good only when d and T are small; when d and T
are as great as for investment C in Exhibit 1, the approximation will be downright poor. To illustrate the
equation, Exhibit 1 includes values for NBC, d, T, and POP for the two investments A and B already
discussed, and for a third investment, C, especially constructed to appear extraordinary. Because C
combines a long-term commitment (100 months) with an extremely high IRR (114% annually with
compounding), PV and NBC are both high; POP, moreover, is low, being affected by the IRR but not by
the length of commitment. Note that T is shorter for C than for B (26.3 vs. 32.3 months), although B's
total commitment is shorter than C's (80 vs. 100); the reason is C's high IRR.

Although the tabulated numbers indicating pref- erence rank investment C a clear first, they leave
doubts about A and B, as already indicated. The rank- ing based on PV or NBC conflicts with that based
on IRR or POP. Some insight into this conflict can be gained by expressing NBC through the
approximation in formula (1), thus
For A: NBC ~ 1.83 X 14.1 = 0.26
For B: NBC - 1.19 X 32.3 = 0.38

The implication here is that the ranking based on NBC (or PV), with discounting at 1% per month, puts
more weight on the long time period T = 32.3 than on the high differential return d = 1.83. But should it?
Essentially, A has the advantage of rapid growth coupled with a relatively high return; B has the advan-
tage of locking in a lesser but still good return for a much longer period. The problem then is to evaluate
the trade-off between these advantages; there is no easy solution, but additional insights will be offered
in the next section.

Multiple Cash-Flow Series For a Single Investment

When simplicity is the goal of investment analysis, any one investment can be reduced to a single cash-
flow series by strong-arm methods - by making enough simplifying assumptions and ignoring all in-
formation that does not conform to a convenient pattern. When comprehensiveness is the goal, how-
ever, many an investment can be far better repre- sented by a multiplicity of cash-flow series than by
any one alone. Multiple cash-flow series result from alternative assumptions concerning performance.
For a clear-cut example, consider an issue of callable bonds - say, New Jersey Bell Telephone 145/8%
debentures of 1 March 2021, which are callable as a whole or in part on or after 1 March 1986 at prices
beginning at 111.51 and declining stepwise to par on 1 March 2017. Al- though these are rated triple-A,
their future perform- ance is by no means certain. The actual cash-flow series may terminate at maturity
with a payment at par plus interest, or much earlier with a payment at the call price plus interest. To
allow for this uncertain- ty, a curious bond buyer can investigate cash-flow series corresponding to
various assumptions concerning call - say, call at the earliest date, and then at some intermediate date;
then for each such series he can calculate a yield to call, arriving at one or more alternatives to the
standard yield to maturity. For further analysis, see Homer and Leibowitz [9, pp. 58-64, 163-167].

For investments in plant and equipment, the cash- flow series consists not of contractual payments, as
with bonds, but of estimates and forecasts by engineers, accountants, and other experts; it is thus even
more uncertain than a series for bonds, and depends critically on assumptions concerning physical
efficiency, service life, obsolescence, future prices, allocations of cost, competition, and much more. For
each possible set of assumptions there will be a different cash-flow series, each with its own IRR, POP, or
NBC. To limit the analysis to just one of these series - even if it corresponds to assumptions thought
most probable - is to ignore much relevant information and to sacrifice valuable insight. The alternative,
of course, is not to analyze all conceivable series, an impossible task leading only to confusion, but to
compromise on a manageable set of series judiciously selected to cover a spectrum of contingen- cies
broad enough to give the responsible financial manager an adequate appreciation of the more ob- vious
risks and uncertainties associated with the in- vestment projects under consideration.
Multiple cash-flow series may also serve to in- vestigate alternative assumptions concerning the
reinvestment of repayments - a matter of particular appeal to investors whose goal is accumulation
rather than income; examples include the company wishing to expand by ploughing back earnings, or
the manager of a pension fund during an initial period of rapid growth when there will be contributions
and security income to invest, but no benefits to pay out.2 A procedure for analyzing accumulation
quantitatively starts with the more or less arbitrary assumption of an accumulation period and of a rate
of return for the reinvested repayments over this period. Exhibit 2 gives accumulated amounts after 80
months for the invest- ments A, B, and C of Exhibit 1 when repayments are reinvested to earn stated
rates (1% to 1.75%) for the remainder of the 80 months. These accumulated amounts were obtained by
assuming, in effect, that each repayment would be deposited in a hypothetical savings account to earn
interest at the stated rate. Computations are reasonably easy with a hand-held business calculator or a
table of compound interest functions.

The essence of this analysis is the conversion of an original cash-flow series into a new and somewhat
ar- tificial series. For investment A, the original series consists of 30 monthly repayments of $75
following the original outlay of $1,500; the converted series con- sists of a single repayment (amount
depending on the assumed rate) at 80 months after the outlay. Other forms of conversion are possible -
say a split of monthly payments between current income and ac- cumulation. If the $40 repayments for
investment B were split evenly, say, the converted series would con- sist of $20 per month income for
79 months and a final payment consisting of $20 plus accumulation equal to half the tabulated amount
in Exhibit 2 ($3,054, e.g., for a rate of 1.50%).

When converted cash-flow series all start with the same initial amount and terminate with a single
repay- ment on the same date, as in Exhibit 2, the ac- cumulated amounts suffice as numbers indicating
preference. More generally, however, adjustments will be required to put all series on a comparable
basis - say a computation of IRR for each converted series. For Exhibit 2, IRRs are easy to compute, as
they rep- resent the growth rates required to bring the initial in- vestment of $1,500 up to the tabulated
amounts in 80 months. For the amount $5,927 corresponding to 1.50% for investment A, the required
rate, or implied IRR, is 1.73%, which may be interpreted as a sort of weighted average - of the original
IRR (2.83%) and the rate earned on reinvestment (1.50%).

The possibility of using converted series and ac- cumulated amounts was discussed by Solomon [10],
who wished to resolve the conflict between rankings based on IRR and those based on PV or NBC.
Solomon sought a procedure "that always provides a unique and correct basis for decision making." But
because accumulated amounts depend on assumed periods of accumulation and rates of return, they
hardly provide uniqueness. In Exhibit 2, for example, A ranks ahead of B if the assumed rate is 1.75% (or
more), but behind B if the rate is 1.50% (or less). As long as there is uncertainty over the proper rate of
return to assume, ranking by accumulated amount is also uncertain.

Even if Solomon's proposed use of accumulated amounts fails the test of uniqueness, it still provides
valuable insights into the conflict between IRR and PV, and it promotes comprehensiveness. Above all, it
emphasizes the importance of looking beyond the strict boundaries of the investment opportunities im-
mediately available, and of exploiting any relevant in- formation on future opportunities. Investments A
and B cannot be adequately appraised on the basis of measures like IRR and POP, which are uniquely
defined by the cash-flow series, or even measures like PV and NBC, which are defined by the same series
after discounting by an estimated cost of capital. Of the two investments, A offers relatively rapid pay-
back - clearly an advantage in the event of a near- term credit crunch, or of opportunities to make new
investments at high rates. But the rapid payback may prove embarrassing if investment opportunities
dry up or if rates of return decline in the near future; then the longer-term investment B will look
attractive because of the locked-in return. The calculation of ac- cumulated amounts may not settle the
question, posed earlier, of whether the advantages of rapid payout out- weigh the disadvantages or vice
versa, but it forces the analyst and the financial manager to face the issue. Looking ahead is desirable,
even for those with less than twenty-twenty vision.

A highly specialized application of converted cash- flow series arises in the analysis of multiple IRRs
resulting from multiple changes of sign within the original series. One way of dealing with multiple IRRs
is to convert the original cash-flow series into an alter- native form with a single change in sign, and
hence a single IRR. Grant, Ireson, and Leavenworth [8, Appendix B] illustrate a method of converting the
series by accumulating a segment of it at an assumed "auxiliary interest rate;" for perspective these
writers typically use several auxiliary rates, and permit some variation in the period of accumulation.
Another method of conversion, suggested by Solomon [10], is to discount (rather than accumulate) a
segment of the original series. But note, because these tricks are anything but unique, they do not
entirely eliminate the problem of multiple IRRs; if an analyst uses three assumed auxiliary rates for
converting a series with two IRRs, he will end up with three new series and three new IRRs. The
advantage of the procedure is not in providing uniqueness, but in providing insight.
Conclusion: Simplicity vs. Comprehensiveness

In investment analysis for capital budgeting, the opportunities to achieve comprehensiveness by using
multiple numbers to indicate preference are legion. Even though the opportunities may be distinctly
limited for single, uniquely defined cash-flow series, they become multiplied whenever the use of alter-
native cash-flow series is indicated by a need to consider alternative assumptions concerning either per-
formance or reinvestment of receipts. To suppose that any imaginative analyst or responsible financial
manager, interested in a comprehensive view, would be content to base an important appraisal and the
sub- sequent investment decision on just one of the many useful numbers available is on a par with
supposing that a hungry gourmet at a smorgasbord would be content to make a whole meal of just one
variety of pickled herring. The problem (cf. [4, p. 34]) is to select a balanced meal while avoiding
indigestion - or, put otherwise, to strike a reasonable trade-off between simplicity and
comprehensiveness.

In theory, perhaps, one might argue that an optimal trade-off between simplicity and
comprehensiveness might be determined by expanding the use of multiple numbers to the point where
marginal cost equals marginal revenue; in practice, however, such a procedure is hardly applicable
because of the difficulty of measuring the costs and benefits, both of which depend heavily on
intangibles - such as the value of information and the cost of confusion. At best, the theoretical
reference to marginal costs and benefits provides a warning that either extreme, whether pure
simplicity or total comprehensiveness, is not optimal; it invites us to strive for a happy medium, even if
we have to rely heavily on judgment in doing so.
How practitioners achieve, or try to achieve, an ap- propriate trade-off has certainly not been
determined, and at best is only roughly determinable. Question- naires suffice to determine the more
obvious rules of formal procedure, such as specification of primary and secondary techniques, but they
shed little light on informal rules and subtleties. A company's formal policy might specify, say, that IRR
was to be used as a primary number in conjunction with POP and NBC as secondary numbers, but then
not specify precisely how these three numbers were to be coordinated, or what additional numbers
(tertiary and quaternary) might be used to aid in clarifying particularly complex analyses.

Supremely elusive is the question of just how cash- flow series for actual analysis are to be chosen from
the virtually unlimited set of conceivable choices. Can the rules of choice be so precisely formulated that
a questionnaire can reliably record them? Even when formal policy limits choice to just one series, it
cannot specify precisely which series, and it cannot prevent the analysts from making an informal
analysis of several series before they finally select one for the final, formal, and official analysis. By way
of summary, multiple numbers to indicate preference are both useful and used, although the fine points
of using them are elusive. When a system for making investment decisions is simple enough to describe
unambiguously, it must be suboptimal; there are always opportunities, however concealed, to im- prove
on the system by going outside it and exploiting information not admitted by it - even if there is no
guarantee that those who try to beat the system will actually succeed. Essentially, the role of so-called
decision rules in capital budgeting is not to make the actual decisions, but to provide the decision-
makers with a point of departure from which they can start out on a difficult and uncertain journey.